Federal Tax Considerations and Uses of Life Insurance
Death benefit and proceeds
Death proceeds are generally received income tax free under IRC §101(a). Interest paid on proceeds left with the insurer is taxable. The transfer-for-value rule removes the income-tax exclusion when a policy is sold to a third party, except transfers to the insured, a partner, a partnership, a corporation in which the insured is a shareholder or officer, or a transferee who takes the insured's basis (e.g., a divorce decree).
Living values and MECs
Cash value grows tax deferred. A policy that fails the seven-pay test is a modified endowment contract: withdrawals and loans are taxed income first, plus a 10% penalty on gains before 59½, though the death benefit stays tax free. Dividends are generally a return of premium. Individual life premiums are not deductible.
Deductibility and business uses
Employer-paid group term coverage is deductible, but coverage above $50,000 creates imputed income for the employee; the death benefit is tax free to the beneficiary. Key person premiums are not deductible while proceeds are tax free. Business applications include buy-sell (entity or cross-purchase), key person, split dollar, executive bonus (§162), and deferred compensation.
Estate planning
Proceeds are included in the insured's gross estate if the insured holds incidents of ownership. An ILIT removes proceeds from the estate but a three-year look-back applies to transferred policies. The unlimited marital deduction can defer tax with proper planning.
Qualified plans
Pension, profit sharing, 401(k), 403(b), IRA/Roth IRA, SEP, and SIMPLE plans allow deductible contributions (Roth uses after-tax dollars), tax-deferred growth, ordinary-income taxation on traditional distributions, a 10% penalty before 59½ with exceptions, and required minimum distributions.
Rule of thumb
If cash leaves a life policy while the insured is alive, ask two questions: is it a MEC, and is the policy surrendered? Those answers determine whether gain is taxable.